Transcript Relevant Cost Decisions - METU | Middle East Technical

Relevant Cost Decisions
DECISION MAKING IN THE SHORT
TERM
Decisions
 A decision model is a formal method
of making a choice, often involving
both quantitative and qualitative
analyses
 A relevant cost is a cost that
differs between alternatives.
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Five-Step
Decision-Making Process
Step 1:
Obtain
Information
Step 2:
Make
Predictions
About
Future
Costs
Step 3:
Choose
An
Alternative
Step 4:
Implement
The
Decision
Step 5:
Evaluate
Performance
Feedback
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Relevance
 Relevant Information has two
characteristics:
 It occurs in the future
 It differs among the alternative courses
of action
 Relevant Costs – expected future
costs
 Relevant Revenues – expected future
revenues
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Identifying Relevant Costs
Costs that can be eliminated (in whole or in
part) by choosing one alternative over
another are avoidable costs. Avoidable
costs are relevant costs.
Unavoidable costs are never relevant and
include:
 Sunk costs.
 Future costs that do not differ between the
alternatives.
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Identifying Relevant Costs
 gather all costs associated with the
alternatives
 eliminate all sunk costs
 Eliminate all future costs that don’t
differ between alternatives
 left are the avoidable costs
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Irrelevance
 Historical costs are past costs that
are irrelevant to decision making
 Also called Sunk Costs- cost that has
already been incurred and that cannot be
avoided regardless of what a manager
decides to do
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Types of Information
 Quantitative factors are outcomes
that can be measured in numerical
terms
 Qualitative factors are outcomes that
are difficult to measure accurately in
numerical terms, such as satisfaction
 Are just as important as quantitative
factors even though they are difficult to
measure
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Terminology
 Incremental Cost – the additional
total cost incurred for an activity
 Differential Cost – the difference in
total cost between two alternatives
 Incremental Revenue – the additional
total revenue from an activity
 Differential Revenue – the difference
in total revenue between two
alternatives
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Types of Decisions
One-Time-Only Special Orders
Insourcing vs. Outsourcing
Make or Buy
Product-Mix
Customer Profitability
Branch / Segment: Adding or
Discontinuing
 Equipment Replacement






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One-Time-Only Special Orders
 Accepting or rejecting special orders
when there is idle production capacity
and the special orders have no longrun implications
 Decision Rule: does the special order
generate additional operating
income?
 Yes – accept
 No – reject
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One-Time-Only Special Orders
 Compares relevant revenues and
relevant costs to determine
profitability
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Special Orders
 Acki Company receives a one-time order that
is not considered part of its normal ongoing
business.
 Acki Company only produces one type of
silver key chain with a unit variable cost of
TL 16. Normal selling price is TL 40 per unit.
 A company in KKTC offers to purchase 3,000
units for TL 20 per unit.
 Annual capacity is 10,000 units, and annual
fixed costs total TL78,000, but Acki company
is currently producing and selling only 5,000
units.
Should Acki accept the offer?
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Special Orders
Acki Company
Contribution Income Statement
Revenue (5,000 × TL40)
TL200.000
Variable costs:
Direct materials
TL40.000
Direct labor
10.000
Manufacturing overhead
20.000
Marketing costs
10.000
Total variable costs
80.000
Contribution margin
120.000
Fixed costs:
Manufacturing overhead TL78.000
Marketing costs
25.000
Total fixed costs
103.000
Net income
TL17.000
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Special Orders
If Acki accepts the offer, net income will
increase by TL 12.000.
Increase in revenue (3,000 × TL20)
Increase in costs (3,000 × TL16 variable cost)
Increase in net income
TL60.000
48.000
TL12.000
Using the incremental approach:
Special order contribution margin = TL20 – TL 16 = TL 4
Change in income = TL 4 × 3,000 units = TL 12.000.
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Potential Problems with
Relevant-Cost Analysis
 Avoid incorrect general assumptions
about information, especially:
 “All variable costs are relevant and all
fixed costs are irrelevant”
 There are notable exceptions for both
costs
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Potential Problems with
Relevant-Cost Analysis
 Problems with using unit-cost data:
 Including irrelevant costs in error
 Using the same unit-cost with different
output levels
 Fixed costs per unit change with different
levels of output
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Avoiding Potential Problems with
Relevant-Cost Analysis
 Focus on Total Revenues and Total
Costs, not their per-unit equivalents
 Continually evaluate data to ensure
that they meet the requirements of
relevant information
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Insourcing vs. Outsourcing
 Insourcing – producing goods or
services within an organization
 Outsourcing – purchasing goods or
services from outside vendors
 Also called the “Make or Buy” decision
 Decision Rule: Select the option that
will provide the firm with the lowest
cost, and therefore the highest profit.
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Qualitative Factors
 Nonquantitative factors may be
extremely important in an evaluation
process, yet do not show up directly
in calculations:




Quality Requirements
Reputation of Outsourcer
Employee Morale
Logistical Considerations – distance from
plant, etc.
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Opportunity Costs
 Opportunity Cost is the contribution to operating
income that is forgone by not using a limited resource
in its next-best alternative use
 “How much profit did the firm ‘lose out on’ by not
selecting this alternative?”
 The economic benefits that are foregone as a result
of pursuing some course of action. Opportunity costs
are not actual dollar outlays and are not recorded in
the accounts of an organization.
 Special type of Opportunity Cost: Holding Cost for
Inventory. Funds tied up in inventory are not
available for investment elsewhere
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The Make or Buy Decision
A decision concerning whether an item
should be produced internally or
purchased from an outside supplier is
called a “make or buy” decision.
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The Make or Buy Decision
 MA Company is thinking of buying a part that is
currently used in one of its products from
outside.
 The unit cost to make this part is:
Direct materials
Direct labor
Variable overhead
Depreciation of special equip.
Supervisor's salary
General factory overhead
Total cost per unit
TL/ u
27
15
3
9
6
30
90
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The Make or Buy Decision
 General factory overhead is allocated on the
basis of direct labor hours and is not going to
change if the parts are bought from outside.
 The 90TL unit cost is based on 20,000 parts
produced each year.
 An outside supplier has offered to provide
the 20,000 parts at a cost of 70TL per part.
Should we accept the supplier’s offer?
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The Make or Buy Decision
Sunk Cost
Outside purchase price
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
Cost
Per
Unit
70
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15
3
9
6
30
90
Cost of 20,000 Units
Buy
Make
1.400.000
540.000
300.000
60.000
0
120.000
0
1.020.000
1.400.000
Not avoidable and is irrelevant. If the product is dropped, it will
be reallocated to other products.
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The Make or Buy Decision
DECISION RULE
In deciding whether to accept the outside
supplier’s offer, MA isolated the relevant
costs of making the part by eliminating:
 The sunk costs.
 The future costs that will not differ
between making or buying the parts.
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Product-Mix Decisions
 The decisions made by a company
about which products to sell and in
what quantities
 Decision Rule (with a constraint):
choose the product that produces the
highest contribution margin per unit
of the constraining resource
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Utilization of a Constrained
Resource
 Firms often face the problem of
deciding how to best utilize a
constrained resource.
 Usually, fixed costs are not affected
by this particular decision, so
management can focus on
maximizing total contribution
margin.
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Utilization of a Constrained
Resource
UM Company produces two products and
selected data is shown below:
Product
Selling price per unit
Less variable expenses per unit
Contribution margin per unit
Current demand per week (units)
Contribution margin ratio
Processing time required
on machine A1 per unit
1
TL60
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TL24
2.000
40%
1,00 min.
2
TL50
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TL15
2.200
30%
0,50 min.
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Utilization of a Constrained
Resource
 Machine A1 is the constrained resource.
There is excess capacity on all other
machines. Machine A1 is being used at
100% of its capacity, and has a capacity
of 2,400 minutes per week.
Should UM focus its efforts on
Product 1 or 2?
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Utilization of a Constrained Resource
Let’s calculate the contribution margin per unit of the
constrained resource, machine A1.
Product
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute
÷
1
TL24
1,00 min. ÷
TL24 min.
2
TL15
0,50 min.
TL30 min.
Product 2 should be emphasized. Provides more
valuable use of the constrained resource machine A1,
yielding a contribution margin of TL 30 per minute as
opposed to TL 24 for Product 1.
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Utilization of a Constrained
Resource
Let’s calculate the contribution margin per unit of the
scarce resource, machine A1.
Let’s see how this plan would work.
Product
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute
÷
1
TL24
1,00 min. ÷
TL24 min.
2
TL15
0,50 min.
TL30 min.
If there are no other considerations, the best plan would be
to produce to meet current demand for Product 2 and then
use remaining capacity to make Product 1.
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Utilization of a Constrained
Resource
Let’s see how this plan would work.
Allocation of Constrained Resource
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2
Total time available
Time used to make Product 2
Time available for Product 1
Time required per unit
Production of Product 1
×
2.200 units
0,50 min.
1.100 min.
÷
2.400
1.100
1.300
1,00
1.300
min.
min.
min.
min.
units
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Utilization of a Constrained
Resource
According to the plan, we will produce 2,200 units of
Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.
Production and sales (units)
Contribution margin per unit
Total contribution margin
Product 1
1.300
TL24
TL31.200
Product 2
2.200
TL15
TL33.000
The total contribution margin for UM is TL 64,200.
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Managing Constraints
Finding ways to
process more units
through a resource
bottleneck
Produce only
what can be sold.
At the bottleneck itself:
•Improve the process
• Add overtime or another shift
• Hire new workers or acquired
more machines
• Subcontract production
Eliminate waste.
Streamline production process.
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Adding or Dropping Customers
 Decision Rule: Does adding or
dropping a customer add operating
income to the firm?
 Yes – add or don’t drop
 No – drop or don’t add
 Decision is based on profitability of
the customer, not how much revenue
a customer generates
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Adding or Discontinuing
Branches or Segments
 Decision Rule: Does adding or
discontinuing a branch or segment
add operating income to the firm?
 Yes – add or don’t discontinue
 No – discontinue or don’t add
 Decision is based on profitability of
the branch or segment, not how
much revenue the branch or segment
generates
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Adding/Dropping Segments
Digital Musical Instruments
Income Statement for 2007
Sales
1.000.000
Less: variable expenses
Variable mfg. costs
240.000
Variable shipping costs
10.000
Commissions
150.000
400.000
Contribution margin
600.000
Less: fixed expenses
General factory overhead
120.000
Salary of line manager
180.000
Depreciation of equipment
100.000
Advertising - direct
200.000
Should the company
drop digital instruments
Rent - factory space
140.000
division?
General admin. expenses
60.000
800.000
Net loss
(200.000)
General Factory Overhead and General Administrative Expenses are unavoidable
costs.
Assume that the equipment used in manufacturing digital instruments has no resale value or
alternative use.
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Incremental Approach
DECISION RULE
UM should drop the digital instruments
division only if the avoided fixed costs
of the division exceed lost
contribution margin of this division.
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Incremental Approach
Contribution Margin
Solution
Contribution margin lost if digital
instrument division is dropped
Less fixed costs that can be avoided
Salary of the line manager
180.000
Advertising - direct
200.000
Rent - factory space
140.000
Net disadvantage
(600.000)
520.000
(80.000)
What about depreciation?
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Comparative Income Approach
Prepare comparative income statements
showing results with and without the
digital instruments division.
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Comparative Income Approach
Solution
Sales
Less variable expenses:
Mfg. expenses
Freight out
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising - direct
Rent - factory space
General admin. expenses
Total fixed expenses
Net loss
Keep Digital
Instrum ents
Drop Digital
Instrum ents
1.000.000
0
0
0
0
0
0
0
240.000
10.000
150.000
400.000
600.000
120.000
180.000
100.000
200.000
140.000
60.000
800.000
(200.000)
120.000
0
100.000
0
0
60.000
280.000
(280.000)
Difference
(1.000.000)
240.000
10.000
150.000
400.000
(600.000)
0
90.000
0
100.000
70.000
0
260.000
(340.000)
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Joint Product Costs
 In some industries, a number of end
products are produced from a single raw
material input.
 Two or more products produced from a
common input are called joint products.
 The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.
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Joint Products
Joint
Input
Joint
Costs
Oil
Common
Production
Process
Gasoline
Chemicals
Split-Off
Point
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Joint Products
Joint
Costs
Joint
Input
Common
Production
Process
Oil
Gasoline
Chemicals
Split-Off
Point
Separate
Processing
Final
Sale
Final
Sale
Separate
Processing
Final
Sale
Separate
Product
Costs
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The Pitfalls of Allocation of Joint
Costs
 Joint costs are really common costs
incurred to simultaneously produce a
variety of end products.
 Joint costs are often allocated to end
products on the basis of the relative
sales value of each product or on
some other basis.
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Sell or Process Further
Decision Rule:
 It will always profitable to continue
processing a joint product after the
split-off point so long as the
incremental revenue exceeds the
incremental processing costs incurred
after the split-off point.
Let’s look at the Kere example.
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Sell or Process Further
 Kere Company cuts logs from which
unfinished lumber and sawdust are the
immediate joint products.
 Unfinished lumber is sold “as is” or
processed further into finished lumber.
 Sawdust can also be sold “as is” to
gardening wholesalers or processed
further into “ready-logs.”
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Sell or Process Further
Data about Kere’s joint products includes:
Sales value at the split-off point
Sales value after further processing
Allocated joint product costs
Cost of further processing
Per Log
Lumber
Sawdust
TL140
TL40
270
176
50
50
24
20
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Sell or Process Further
Analysis
Per Log
Lumber
Sales value after further processing
Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing
TL270
140
130
50
TL80
Sawdust
TL50
40
10
20
(TL10)
Should Kere process the lumber
further and sell the sawdust “as is?”
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Behavioral Implications
 Despite the quantitative nature of
some aspects of decision making, not
all managers will choose the best
alternative for the firm
 Managers could engage in selfserving behavior such as delaying
needed equipment maintenance in
order to meet their personal
profitability quotas for bonus
consideration
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